In a prior post (here), I described the growing litigation risk arising out of credit default swap (CDS) transactions. In their recent overview of subprime-related litigation entitled “The Pebble and the Pool: The (Global) Expansion of Subprime Litigation” (here), John Doherty and Richard Hans of the Thacher Proffitt and Wood law firm note that “more lawsuits involving credit default swaps are likely to be initiated in the near future, as the current trend has the potential for huge losses resulting from the defaults on ‘high-yield’ or ‘junk” bonds in connection with the general market failure.”

In a June 1, 2008 article entitled “First Came the Swap. Then It’s the Knives” (here), New York Times columnist Gretchen Morgenson takes a close look at one failed CDS transaction and the litigation that has followed, about which she quotes “experts” as saying that the case is “the first of what will likely be a flood of disputes between big banks and hedge funds that typically strike swap deals.”

The swap involved was issued by a Paramax Capital hedge fund in early 2007 to insure $1.31 bilion of AAA-rated super senior notes that “reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.” The Paramax fund, which itself had just $200 million in capital, organized a special purpose entity capitalized with just $4.6 million, to conduct the swap. Paramax was to receive an annual fee of 0.155 percent of the notes’ $1.31 billion value (or slightly more than $2 million), and would be subject to additional collateral requirements if the notes’ value declined.

Over the course of 2007, UBS presented escalating requirements that Paramax post a total of $33 million in additional collateral. When Paramax refused, UBS sued. According to the Times article, Paramax now contends that a UBS managing director (no longer with the company) induced Paramax to enter the transaction, and to address Paramax’s concern that it might be called upon to post additional collateral, reassured Paramax that the mark-to-market risk on the underlying securities was low because UBS used “subjective valuations” designed to reduce the impact of market fluctuations.

As detailed further in the Times article, there are a number of interesting things about this transaction. From my perspective, the most noteworthy aspect is that UBS considered a special purpose entity with only $4.6 million in capital to be an appropriate source of default insurance for instruments with a face value of $1.31 billion. UBS’s contractual right to demand additional collateral from the hedge fund, which itself had capital of only $200 million (which presumably was deployed in other ways and accordingly unavailable in its entirety as additional collateral), seems a woefully inadequate explanation for this transaction.

The Naked Capitalism blog (here) notes that “UBS was clearly well aware of Paramax’s limits, so the next question is: was UBS solely responsible for pulling a fast one on the CDO buyers or is Paramax a co-conspirator?”

This litigation between UBS and Paramax resembles the CDO Plus litigation I discussed in my prior post (here) about swaps. In those cases as well, a thinly capitalized hedge fund was unable to meet demands for additional collateral and wound up in litigation with the large commercial banks that had purchased CDS protection from the fund. As consequences from the credit crisis continue to roll through the financial marketplace, CDS counterparties are likely to face further collateral demands, which can only fuel further litigation.

But the counterparties themselves are not the only potential litigants. Behind the CDS purchaser are the investors who made investments in the belief that the investment interests were “insured” against default. As it emerges that this insurance depended upon facially inadequate counterparties, investors may join the fray. As the Naked Capitalism blog post linked above notes, “since over 30% of the credit default swaps were written by hedge funds, many of whom were probably as incapable as Paramax of performing in the event of default, it’s not unreasonable to assume that some of these CDS lawsuits will lay the groundwork for investor litigation.”

Another aspect of the role of CDS in the financial marketplace is leading to yet another variety of CDS-related litigation. That is, because there is no requirement that a CDS buyer hold the underlying instruments, swaps are often used as a means to speculate on interest spreads. That means that these instruments can serve an investment purpose separate apart from their insurance purpose.

The problem for companies that have used swaps for investment purposes is that as a result of the credit turmoil, the market for these instruments in an uproar, and the instruments’ valuation has become uncertain. Indeed, as recent circumstances have shown, these valuation issues are present whether a company holds the swap as an investor or as an insurer. Several of the most significant recent financial institution asset write-downs have involved these CDS valuation uncertainties; for example, a substantial part of the recent write-downs of Swiss Re and of American International Group related to CDS valuation issues. Significantly, in both instances, shareholders litigation ensued following the write-downs. (Refer here regarding the Swiss Re litigation and refer here regarding the AIG litigation). It seems highly improbable that there will not be further shareholder litigation over these CDS valuation issues.

As reflected in the June 6, 2008 Wall Street Journal (here), the recent signs are that the turmoil in the financial marketplace is far from over , as a result of which the pressure on CDS will remain, and there likely will be further litigation. Even if only a tiny percentage of CDS transactions beget litigation, the problem could be huge. According to the International Swaps and Derivatives Association (here), the aggregate notional value of credit defaults swaps outstanding at the end of 2007 was $62 trillion, an amount which arguably exceeds the value of bank deposits worldwide. It is nearly three times the value of the U.S. stock markets.

With numbers that astronomical, even a small sliver represents a mammoth problem. With nominal values of $62 trillion, issues concerning valuation present a potentially frightening prospect for companies, their investors, and their insurers. As Time Magazine said in its recent article entitled “Credit Default Swaps: The Next Crisis?” (here), “a meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis.”

Susan Mangiero has an interesting post (here) on her Pension Risk Matters blog about these issues.

The “Pebble in the Pool” article I linked to above presents a very good overview of the subprime-related litigation generally and is worth reviewing on its own for those purposes.

Another Subprime-Related Lawsuit Against Mutual Fund: On June 5, 2008, plaintiffs’ attorneys initiated a securities class action lawsuit in the United States District Court for the District of Massachusetts under the Securities Act of 1933 on behalf of purchasers of the Fidelity Ultra-Short Bond Fund who purchased their fund shares within three years of the lawsuit’s filing.

According to the complaint (which can be found here), the defendants in the lawsuit include Fidelity Management & Research Company, which is the investment advisor to the Fidelity mutual funds, and related entities, and also include the 21 individual trustees of the Ultra-Short Bond Fund.

According to the plaintiffs’ lawyers’ June 5, 2008 press release describing the complaint (which can be found here), the plaintiffs allege that the defendants solicited investors to purchase fund shares by making statements that described the fund as a fund that “(i) “Seeks a high level of current income consistent with the preservation of capital”; (ii) “allocates its assets across different market sectors and maturities”; (iii) has a “similar overall interest rate risk to the Lehman Brothers® 6 Month Swap Index”; and (iv) is geared toward the “preservation of capital.”  

The complaint alleges that these statements were false because “defendants did not adequately disclose the risks associated with investing in the Fund, including, for example, that the Fund was: (i) failing to compete with the Lehman Brothers® 6 Month Swap Index; and (ii) so heavily invested in high-risk mortgage-backed securities.”

I have added this case to my running tally of subprime-related litigation, which can be found here. With the addition of this lawsuit, the tally now stands at 86 subprime-related securities class action lawsuits, of which 46 have been filed in 2008.

I note that by my count, this new lawsuit represents the fourth subprime-related lawsuit against a mutual fund or mutual fund family. The other include Calamos Global Dynamic Income Fund (about which refer here), Regions Morgan Keegan Funds (refer here), and the Schwab Yield Plus Fund (refer here).

For many companies, one of the hardest parts of the D&O insurance transaction is determining how much insurance to buy. Against a backdrop of basic affordability, the company must consider complex issues of limits adequacy – that is, how much insurance is “enough”? These issues are even more fraught in a time of generally rising claims severity (about which, refer here).

 

As discussed below, recent developments in one current claim underscore the fact that in addition to rising settlement levels, escalating defense expense is an increasingly important part of the limits adequacy equation. In addition, these recent developments also demonstrate that many related issues should also weigh into the limits adequacy analysis, and these same issues also have important implications for the structure of the insurance program, as well.

 

University of Denver Law Professor J. Robert Brown, Jr. has a post today (here) on his indispensable blog, The Race to the Bottom, discussing developments involving Paul Barnaba, a former employee of bankrupt auto parts supplier Collins & Aikman. Barnaba is caught up in the criminal case involving David Stockman, the former head of the OMB under Ronald Reagan, who was C&A’s CEO from 2001, when Stockman’s private equity fund took control of C&A, until shortly before the company’s 2005 bankruptcy. Barnaba is described in the indictment as “employed by the purchasing department” and identified as Director of Financial Analysis and eventually Director and Vice President of Purchasing for the Plastics Division. Background regarding the criminal prosecution can be found here.

 

As Professor Brown explained in an earlier post (here), Barnaba has moved to sever his criminal case from the other criminal defendants and to set the case for an early trial date. Barnaba asserts that, due to his indictment, he faces overwhelming personal and professional difficulties. He also argues that the protracted criminal proceedings threaten him with financial ruin, and he contends further that the proceeds of the applicable D&O policy “are quickly dwindling.”

 

The government opposed Barnaba’s motion, arguing among other things that Barnaba’s concerns about the dwindling D&O insurance are “wholly speculative and unsubstantiated.”

 

In his Reply to the government’s opposition, Barnaba vigorously disagrees with the government’s attempt to belittle his concerns about the dwindling D&O policy. His Reply explains that Collins & Aikman has a $50 million insurance program arranged in four layers. This insurance “provides coverage to a wide variety of former Collins & Aikman executives and employees,” including not only the criminal defendants, but also “those who have been sued or subpoenaed in the civil SEC matter, and those who have been sued or subpoenaed in various class actions and other civil suits.”

 

Barnaba explains in his Reply that the first $15 million layer of coverage was exhausted on or about June 15, 2007, and the second $15 million layer was exhausted on or about March 31, 2008 (for defense work completed through February 2008). As Barnaba notes, “the second $15 million layer of coverage was exhausted in nine months at a rate of approximately $1.67 million per month” and he adds that the “monthly rate was higher at the end of than at the beginning of this nine-month period.”

 

In any event, for the defense work completed in March 2008 and later, only $20 million of coverage remains. Barnaba argues that “[a]ssuming a monthly burn rate of $2 million to $3 million, which is realistic and likely conservative, all policy proceeds will be exhausted sometime between mid-September 2008 and December 31, 2008. This is not speculative.”

 

It is hard not to sympathize with Barnaba’s plight, regardless of the merits of the criminal matter. He has been caught in the maelstrom. The outcome of his motion to sever and to set a trial date remains to be seen, but it is hard to imagine a court agreeing to allow a high-profile criminal case like this one to be tried piecemeal. The D&O insurance could well be gone long before the case finally goes to trial.

 

Separate and apart from the actual merits of Barnaba’s motion are the implications of his plight for the issue of D&O insurance limits adequacy.

 

The first and most basic point is the importance of defense expense in the limits adequacy analysis. The potential for defense expense to exhaust or substantially deplete the available limits is most obvious in a catastrophic claim like the one involving Collins & Aikman, but even in less catastrophic circumstances, accumulating defense expense can substantially reduce the indemnity protection available even in a large insurance program. And the insurance is supposed to able to respond adequately in all circumstances, even the unlikely event of a catastrophic claim. In considering the requirements that a catastrophic claim can present, it is important to note that the aggregate defense expense related to the Collins & Aikman claim consumed $15 million in just nine months.

 

The second point is that one of the problems in the Collins & Aikman claim is that so many different people are accessing the policy, for a wide variety of different matters. The potential for the policy limits to drain away through so many different access points is perhaps inherent in the current standard D&O policy structure, in which so many different people are included as “insured persons” and so many different kinds of matters fall within the definition of a covered “claim.”

 

While this breadth of coverage is generally viewed as a positive thing from the policyholder’s perspective, it has the inherent potential (a potential that is being dramatically realized in the Collins & Aikman claim) for accelerated policy erosion and even depletion. The erosion potential inherent in the breadth of available policy coverage is a consideration that is too infrequently considered in connection with the question of limits adequacy.

 

Third, the problem Barnaba faces is not just his alone – all of the other “insured persons” are also facing imminent insurance program depletion. Once the available insurance is used up, these individuals will face continued complex litigation without further insurance available to defend or indemnify themselves. Among other things, it could prove difficult and painful for the defendants in the civil lawsuits to extricate themselves without insurance available.

 

All of that said, the solutions to these problems are not easy. With the benefit of hindsight, it is tempting to argue that the company should have carried higher limits. The fact is that many companies of Collins & Aikman’s pre-catastrophe size (the company had a market capitalization of approximately $500 million a year before it went bankrupt) choose to carry D&O limits lower than the $50 million that Collins & Aikman carried. Many companies are unwilling or unable to buy greater limits.

 

In the end the analysis comes down to the perennial question of limits adequacy – that is, how much insurance is enough?

 

In light of the escalating average claims severity, and of the numerous implications from Barnaba’s plight (including the catastrophic potential for defense expense to deplete policy limits), it may be time to rethink commonplace concepts of limits adequacy, because past notions may no longer be sufficient. Average claims severity is increasing. Defense expense does have the catastrophic potential to exhaust policy limits. In addition, new developments, such as the growing opt-out phenomenon (discussed most recently here), pose additional challenges to the traditional limits adequacy analysis.

 

Increased program limits alone, however, may not solve all of the problems. Indeed, it could be argued that even were higher limits available, they might not adequately protect Barnaba and the other Collins & Aikman defendants. Given the astonishing potential for defense expense to consume available insurance (I mean, $15 million in nine months, for crying out loud), even a substantially larger insurance program than the one Collins & Aikman maintained might prove to be insufficient.

 

Part of the solution has to be program structure. Clearly, a key reason that the Collins & Aikman program is melting away is that so many different people are accessing it. One way that well-advised corporate officials can ensure they are not left without insurance to protect them as individuals is through supplemental D&O insurance structures dedicated solely to their own protection. These supplemental structures might take any one of a number of different forms, including for example, excess Side A coverage for a specified group of individuals, or even through an individual D&O insurance policy (so-called IDL coverage). While there are a variety of ways this supplemental insurance might be structured, the crisis Barnaba faces underscores the importance of addressing these issues as part of the insurance acquisition process.

 

One final thought about Barnaba. That is, the typical insurance acquisition process conversation is usually limited to considerations involving the exposures of the most senior corporate officials. The possible exposures of “supporting cast” employees such as Barnaba are usually not a central part of the dialog. For that reason, it is relatively unlikely that the deployment of supplement insurance structures, as important as they are, would do much for someone like Barnaba.

 

In the end, someone at Barnaba’s level is, in all likelihood, going to be (as in the case of Barnaba himself) dependent on the continued availability of insurance proceeds under the traditional D&O insurance policy. This final point underscores the importance of a thorough review of all considerations involved in the issue of limits adequacy, including in particular the number of persons potentially dependent on the policy for protection. As I noted, it may be time to reconsider traditional notions of limits adequacy, in light of all of these considerations.

 

Very special thanks to Professor Brown for providing a heads up about his post.

 

Brocade Settles Options Timing-Related Securities Class Action Lawsuit: According to the company’s June 2, 2008 press release (here), Brocade Communications has reached an agreement to settle the options-backdating related securities class action lawsuit pending against the company and certain of its directors and officers, in exchange for an agreement to pay $160 million. Background regarding the litigation can be found here.

 

I have added the Brocade settlement to my table of options backdating-related settlements and dismissals, which can be accessed here.

 

A WSJ.com Law Blog post about the settlement can be found here.

In October 2000, the SEC promulgated Rule 10b5-1 to provide company insiders with a way to trade their shares in company stock without incurring securities law liability, through the pre-trading adoption of a written trading plan. Despite the Rule’s protective purpose, concerns have arisen more recently about Rule 10b5-1 plan abuses, as I noted in prior posts (here and here).

 

Indeed, concerns about Angelo Mozilo’s possible Rule 10b5-1 plan misuse were an important part of the court’s recent refusal to dismiss the Countrywide subprime-related derivative lawsuit. (My prior post about the Countrywide dismissal denial can be found here. A more detailed analysis of the Countrywide court’s discussion of Rule 10b5-1 plan issues can be found on The Corporate Counsel.net blog, here.)

 

A May 27, 2008 paper by University of Chicago Law Professor Todd Henderson, Stanford Business School Professor Alan Jagolinzer, and Penn State Business Professor Karl Muller entitled “Scienter Disclosure” (here) looks at Rule 10b5-1 plans from a different perspective, asking what can be inferred from a company’s disclosure of its officials’ plans. The authors’ surprising conclusion is that the more detailed a company’s plan disclosure, the more likely are the subsequent trades to capture abnormal trading returns.

 

The starting point of the authors’ analysis is that, although Rule 10b5-1 itself does not require the plans to be disclosed, “disclosure can enhance the legal protection by increasing the likelihood of early dismissal of class action lawsuits.” This “litigation benefit” arises due to the fact a Rule 10b5-1 plan trading defense will only be available at to dismissal stage if the plan is identified and described in the company’s SEC filings (which a court may consider at the initial pleading stage). If the company fully discloses the plan details, “a court may better ascertain that the allegedly fraudulent trades fall within the Rule’s affirmative defense, thereby increasing the possibility of a low-cost dismissal.”

 

From this, the authors infer that companies perceiving a greater litigation risk are “more apt to disclose the existence and details of Rule 10b5-1 plans.” But there are costs associated with disclosing the plans, particularly “if investors infer a price relevant signal from disclosure or if disclosure enhances investors’ monitoring of insiders’ trade plan commitment.” The “signal” might encourage investor “front running” which could deprive the insider of anticipated trading profits. The monitoring “reduces the value of early termination options” the insider might have if a planned trade no longer appears desirable.

 

The authors hypothesized that insiders will nonetheless prefer Rule 10b5-1 plan disclosure if the “scienter disclosure” provides incremental litigation benefit – which is likely to be greatest precisely where the ability to trade provides the greatest opportunity to profit. That is, “pre-disclosure of trade may be strategic in the face of high legal risk if it mitigates legal risk and does not fully reveal privately held information.”

 

The authors examined company disclosures for hundreds of companies during the period between October 2000 and December 2006, and grouped the companies according to whether the companies had low, moderate or detailed Rule 10b5-1 plan disclosure. The authors then correlated the companies’ disclosure and “subsequent firm returns and earning performance.” The authors found that “more specific 10b5-1 plan disclosures are associated with more negative post-trade abnormal returns” and that “the association between sales transactions and subsequent negative performance is increasing in disclosure specificity, after controlling for other factors that are associated with firm returns.”

 

As a group, executives at those companies with the most detailed disclosure avoided an average of 12% loss in the companies’ trades relative to the broader market in the six months following their sales. The authors conclude that “voluntary Rule 10b5-1 plan disclosure is associated with the higher level firm legal risk and a proxy for insider’s potential strategic trade.”

 

In other words, the more detailed disclosure manifests insiders’ perception that subsequent trades are more likely to be advantageous – and therefore legal protection is more likely to be important, justifying the detailed disclosure.

 

These data suggest, and the authors hypothesize, that “investors should respond negatively to specific disclosures regarding 10b5-1 participation, if they infer that insiders have high strategic trade potential for which they seek high litigation protection.” However, the authors found that there is no observable negative investor response to Rule 10b5-1 disclosure.

 

The authors’ conclusions have a number of important implications. Obviously, investors may be missing an important signal related to 10b5-1 disclosure. Another important implication relates to the protection that the Rule affords; the authors’ conclusion that the companies with the most detailed disclosure are also the ones with the most fortunate timing suggests that, at least in some companies, transparency may be facilitating aggressive stock sales. The Rule was designed to provide company officials with a way to trade safely, but the authors’ study suggests that at least some company officials may be using the Rule as a shield to unload stock at an opportune time.

 

While I confess that initially I found the authors’ conclusions troubling, after further reflection I am less concerned. The problem here is not that insiders are using Rule 10b5-1 plans and plan disclosure strategically – after all, the whole idea of the Rule was to facilitate trading, and there is certainly no suggestion that trades made pursuant to the Rule cannot be advantageous. The problem is that at least so far, investors have missed the negative signal that Rule 10b5-1 plan disclosure implies.

 

The authors themselves speculate that the absence of negative investor reaction “may indicate that there are frictions to implementing strategies based on 10b5-1 disclosure signals or that investors do not understand 10b5-1 disclosure implications, which is possible if our same period reflects the transition period regarding 10b5-1 use.” To the extent, however, that the signal is better understood, the more the marketplace itself will discipline the process.

 

The greater likelihood that the mere announcement of a 10b5-1 plan could undermine a company’s share price could provide a missing disciplinary constraint on strategic trading and reduce company officials’ ability to capture abnormal returns. In other words, the whole mechanism will function better if investors appreciate the significance of 10b5-1 disclosure – an appreciation that the authors’ research clearly should facilitate.

 

A May 27, 2008 USA Today article discussing the authors’ study can be found here. An entry on the University of Chicago Law School Faculty Blog discussing the article can be found here.

 

Very special thanks to Professor Henderson for alerting me to the article and for providing me with a link.

 

Another Options Backdating-Related Class Action Settlement: In its May 8, 2008 filing (here), Kratos Defense & Security Solutions (formerly known as Wireless Facilities) announced that in March 2008, it had reached a tentative agreement to settle the options backdating-related securities class action lawsuit pending against the company and certain of its directors and officers. The amount of the settlement is $4.5 million, of which $1.7 million will come from the company and the balance of which will come from the company’s D&O insurer.

 

I have added this settlement to my table of options backdating-related lawsuit settlements and dismissals, which can be accessed here.

 

Hat tip to Adam Savett of the Securities Litigation Watch blog (here) for providing the heads’ up about the Wireless Facilities settlement

 

Not Just Immune, But Infallible: If you were immensely rich and powerful, you too might well, as did the Sultan of Brunei in 2004, amend the constitution to “declare himself infallible and immune from any obligation to appear in court …and to subject anyone who criticizes him to criminal punishment.”

 

Those curious to know how a court might actually apply a provision like this and related legal issues will want to refer to Francis Pileggi’s Delaware Corporate and Commercial Litigation Blog (here), in which Pileggi reviews a May 23, 2008 Delaware Chancery Court decisions involving the Sultan and his brother. Among other things, Pileggi notes that in the course of reaching its decision, the Court “recites the background facts of royal family battles that could be part of a movie script.”

In a development that is in my experience absolutely unprecedented, Phillip Bennett, the former CEO of defunct futures trader Refco, after having pled guilty to criminal charges, is actively cooperating with the lead plaintiffs’ counsel in the civil securities lawsuit pending against the company and its former directors and officers. As discussed below, Bennett’s conduct, in addition to being highly unusual, could also raise some potentially significant insurance coverage questions.

 

A detailed description of the circumstances surrounding Bennett’s cooperation in the class action can be found in a May 28, 2008 article (here) by Bloomberg News reporter Thom Weidlich. The circumstances are also discussed in a WSJ.com Law Blog post (here).

 

Within weeks after it went public in August 2005, Refco announced that Bennett had hidden $430 million in bad debts from the company’s auditors and investors. The details of the scandal can be found here. IPO investors initiated securities class action lawsuits almost immediately. (Refer here for background regarding the class action lawsuit; a website devoted to the lawsuit can be found here.).

 

On February 15, 2008, Bennett pled guilty to bank fraud, conspiracy, money laundering and 17 other charges.

 

In connection with Bennett’s upcoming June 19, 2008 sentencing, counsel for the lead plaintiffs in the class action lawsuit – Sean Coffey of the Bernstein Litowitz firm and Stuart Grant of the Grant & Eisenhofer firm – submitted a letter to the court to provide information they hope “proves helpful as the Court considers the appropriate sentence.” A copy of their letter can be found here.

 

According to the attorneys’ letter, after Bennett pled guilty, his lawyer approached the class counsel to offer cooperation in connection with the civil case. According to their letter, “Bennett has helped to advance our understanding about matters within Refco, providing insights not readily discernable from our ongoing review of documents or cross-examination of deposition witnesses who are almost universally aligned with the defendants.” The letter goes on to report that Bennett has identified “‘red flags’ and other circumstances that would have alerted a diligent gatekeeper that things at Refco were not what they appeared to be.”

 

The letter states that Bennett’s cooperation has “materially strengthened the class claims against a number of defendants.” The defendants specifically mentioned in the letter are Thomas H. Lee, the IPO Underwriters, Grant Thorton, and Mayer Brown. The letter states that:

 

In the opinion of Lead Counsel, his assistance has substantially enhanced the ability of Lead Plaintiffs to hold those defendants more fully accountable for their role in the events resulting in the devastating losses suffered by Refco investors.

 

The Bloomberg article and the WSJ.com Law Blog post linked to above contain remarks from several commentators as to whether the letter will benefit Bennett as his sentencing.

 

There are a number of interesting things about the plaintiffs’ attorneys’ letter. Among other things, Bennett’s cooperation holds the prospect of shifting to Refco’s outside professionals some of the financial consequences for Bennett’s own criminal misconduct, based on their supposed failure to stop or catch him.

 

Another interesting thing, interesting to me at least, is the potential effect from Bennett’s behavior on the D&O insurance coverage that might otherwise be available for other former Refco directors and officers in connection with the Refco securities lawsuit. I emphasize at the outset that I have no direct knowledge of Refco’s D&O insurance program, and I am expressing no views about the availability of coverage under its D&O insurance. My comments here are strictly to note a potential coverage issue that might arise as a result of Bennett’s cooperation with the plaintiffs’ attorneys.

 

The specific insurance issue relates to the possibility that Bennett’s cooperation might trigger the so-called “Insured vs. Insured” exclusion (or IvI as it is more commonly known) that is found in most D&O insurance policies. A typical IvI exclusion provides, among other things, that the insurers is not liable for any loss in connection with a claim “which is brought by any security holder or member of an Organization, whether directly or derivatively, unless such security holder or member’s claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of, any Executive.”

 

Bennett’s extensive cooperation with the plaintiffs – the significance and materiality of which the plaintiffs’ lawyers expressly acknowledged – would appear at least potentially to implicate this D&O policy exclusion. Now, as a result of his criminal plea, Bennett himself would likely no longer have coverage under the policy, as would appear to be the case for other Refco officers who were criminally convicted in April of this year. But the other former Refco directors and officers, if any, who remain as defendants in the civil lawsuit and who have not pled guilty or been criminally convicted, may still hope to have remaining D&O insurance limits available to fund their defense and indemnity. (A number of the individual defendants have already entered settlements with the class, as described here.) Bennett’s cooperation with the plaintiffs could at least potentially raise coverage concerns, to the extent coverage is otherwise available to these persons.

 

In other words, Bennett’s cooperation not only represents a threat to Refco’s former outside advisors, but could also have serious adverse consequences for the company’s former directors and officers.

 

These events, as noted, are highly unusual and unlikely to recur. Nevertheless, the potential insurance issues that Bennett’s conduct could trigger are a reminder that there claims resolution is a complicated process, with a host of potentially significant consequences at every point. Although sometimes overlooked, the insurance issues can sometimes be particularly significant.

Among the many consequences of an increasingly global economy is that investor interest in pursuing claims for securities wrongdoing has become a more nearly universal phenomenon. While collective-style lawsuits largely had been restricted to claims in U.S. courts under U.S. law, a growing list of countries are adopting at least some elements of U.S.-style securities lawsuits. Several recent articles, discussed below, have examined these developments.

First, in a May 19, 2008 article entitled “Global Realm of Securities Class Actions” (here), John J. Clarke Jr. and Keara M. Gordon of the DLA Piper law firm suggest that as U.S. courts “more carefully define the limits” of subject matter jurisdiction for securities lawsuits brought by foreign investors, “a growing list of nations in Europe and elsewhere are adopting procedures akin to American-style class actions.”

The authors find that the recent case law trend suggests “some reluctance by U.S. federal courts to assert jurisdiction over claims of securities fraud” brought by or on behalf of foreign investors who bought their shares in foreign-domiciled companies on foreign exchanges (so-called “f-cubed” litigants, about whom I have previously written here and here). At the same time, the authors note, “a number of nations have adopted procedural mechanisms similar to U.S. class actions in several respects.” The authors specifically examine developments in Australia, Canada, England and Wales, Germany and The Netherlands.

Second, an April 25, 2008 article by Sandeep Savla of Dewey & LeBoeuf entitled “Securities Class Actions in London” (here) suggests that “companies listed on a London exchange must prepare for a wave of securities lawsuits that will increasingly be instituted in England.” Savla cites three reasons why he predicts increasing numbers of English securities lawsuits:

1. A recent English judicial decision in which the court held that a third-party could buy a litigation claim, continue to pursue and fund the litigation and retain any damages awarded. Savla suggest that this decision will incent hedge funds and others to buy and sell securities claims and then litigate the cases for a profit.

2. Apart from acquiring an entire claim, third-parties can now, as a result of other English case law developments, fund litigation in exchange for an opportunity to share in litigation proceeds. Savla believes that private equity firms, hedge funds and other financial firms will be interested in funding litigation in exchange for a large cut of the damages, and that the availability of this funding will remove some of the litigation disincentives of the English “loser pays” attorneys’ fee principles.

3. New statutory liability of misstatements and enhanced rights to bring derivative claims under the Companies Act of 2006 will, Savla asserts, “spur class actions and derivative suits.”

Third, the recent subprime and credit-related crisis may provide an important impetus to these developments. A May 21, 2008 post (here) on the Pom Talk blog (which is published by the plaintiffs’ firm of Pomerantz Hudek Block Grossman & Gross) notes that “several large European banks have been hit with considerable losses stemming from their exposure to U.S. debt,” and these banks “will likely face intense regulatory scrutiny and a wave of litigation.” Many of these suits may wind up in courts outside the U.S. – “if a U.S. court bars foreign investors from suing here, their only recourse would be to sue the banks on their home turf.”

Notwithstanding the traditional reluctance of many countries’ courts to support this type of litigation, “the severity of the subprime impact and resultant losses could prompt otherwise hesitant investors to take action.”

Clearly, a key component of the developments outside the U.S. is the question whether or not the U.S. courts will or will not exercise subject matter jurisdiction over these claims involving foreign investors. A scholarly overview of the U.S. jurisdictional issues can be found in an article in the Winter 2008 issue of the New York International Law Review entitled “Ebb and Flow: The Changing Jurisdictional Tide of Global Litigation” (here).

The article, written by Perry Granof of Chubb and Richard Hans, Samaa Haridi and Jennifer Kozar of Thacher, Profitt and Wood, examines the extend to which “defendants are increasingly seeking to avoid securities class action litigation in the United States – employing both jurisdictional and forum non conveniens arguments.” At the same time, the authors note, “several courts have expressed concern that too restrictive an approach may render U.S. courts ineffective in addressing fraud in an increasingly global securities market.”

Auction Rate Securities Lawsuit Notes: In a recent post (here), I raised questions about the flood of auction rate securities class action lawsuits that have been coming in since mid-March. (My current tally of companies named as defendants in auction rate securities lawsuits, which may be accessed here, now stands at 17.) A May 27, 2008 Bloomberg article entitled “Auction Failure Damages Face Burden of Proof Eluding Lawyers” (here) raises the possibility that the lawyers filing these lawsuits “may be unable to prove their clients lost money or collect fees themselves.”

Among other things, the Bloomberg article quotes a former SEC attorney as saying, with respect to the penalty interest rates that many of the auction rate securities are now paying, “I don’t see how you can get around the fact that, for the most part, the investors are now doing better.” To be sure, investors’ biggest grievance is not the interest rate but the fact that they can’t sell the instruments right now, about which the article quote Columbia Law School Professor John Coffee as saying “I don’t know that you can easily measure liquidity.”

A separate issue pertaining to auction rate securities is how the instruments are to be valued for balance sheet purposes in the absence of a viable marketplace to trade the securities. As I recently noted (here), this problem afflicts a number of publicly traded companies, included quite a few companies entirely outside the financial sector.

A May 27, 2008 Wall Street Journal article entitled “Auction-Rate Securities Give Firms Grief” (here) reports that “hundreds of U.S. companies still are struggling to clean up the problems caused by the auction-rate securities.” The article reports that over 400 companies hold instruments originally valued at over $30 billion, and that “while some companies have written down the value of their auction-rate holdings, many others haven’t, even though market prices have fallen substantially.”  

Hat tip to the WSJ.com Law Blog (here) for the link to the Bloomberg article.

Updating the Options Backdating Lawsuit Count: As a result of a recent post (here) about options backdating settlements, I have had extensive communications with several individuals at NERA Economic Consulting about the total number of options backdating-related securities class action lawsuits. Based on the information NERA provided, I am revising my count of options backdating-related securities class action lawsuits from 36 to 38, by adding to the list Cyberonics (amended complaint here) and The Children’s Place Retail Stores (complaint here).

The revised list of all options backdating related lawsuits can be found here.

Special thanks to Svetlana Starykh and her colleagues at NERA for their friendly and helpful communication on this topic.

 Speak Not, Memory: A May 21, 2008 article in the Cleveland Plain Dealer entitled “Beachwood Man Reports Rate Ability Not to Forget” (here) describes a Beachwood, Ohio resident with a very rare and perhaps enviable talent. (Coincidentally, Beachwood is also the location of The D&O Diary’s intergalactic headquarters.) The article reports that:

Give Rick Baron a date, any date on the calendar, and neurons start firing. He leans his head back and flips through a mental calendar. Then, in an instant, the recollections spurt out.

It’s not just that Baron remembers. He says he can’t forget.

Dates and details sear into his mind with amazing clarity, so much so that he’s being studied by researchers at the University of California-Irvine. He’s one of only three people identified so far with such phenomenal autobiographical memory.

Seemingly trivial details from his life — such as sitting for his sixth-grade picture (Oct. 10, 1968) or going on a date to Euclid’s Lakeshore Cinema to catch the forgettable movie "Problem Child" (Sept. 5, 1990) — easily flow from memory to mouth.

He delights in recalling historical events with near-encyclopedic precision. He says he remembers anything he reads, hears or sees. "Try me," he says. "Ask me anything."

When was Johnny Carson’s last show? ("An easy one — May 22, 1992.") When did militants seize the U.S. Embassy in Iran? ("You playing with me? Nov. 4, 1979.") When did former Cleveland Indian Duane Kuiper hit his only career home run? ("Aug. 29, 1977, off Steve Stone.")

"I don’t dwell on the past," said Baron, 50. "It’s just there."

Always.

At first impression, Mr. Baron, with his vast and perfect memory, seems like a truly enviable person. The frustrations of an unreliable memory are a fact of life for many of us, and are a reality that only becomes more insistent with age. The inconvenience of an occasional memory lapse usually sparks regret that we cannot remember more. Imagine how convenient it would be if we could now recall our college calculus as well as we knew it then, or we could recite procedural rules as precisely as we learned them for the bar exam.

The simple truth is that, for most of us at least, our brains are not wired to remember everything, and life would be immeasurably more difficult if we did.

In his short story, “Funes the Memorius,” Jorge Luis Borges explores these fundamental attributes of memory. In Borges’ story, Funes loses consciousness after falling from a horse. After recovering, he couldn’t forget anything he had seen or heard.

He remembered the shape of the clouds in the south at dawn on the 30th of April of 1882, and he could compare them in his recollection with the marbled grain in the design of a leather-bound book which he had seen only once…He could remember all his dreams, all his fancies. Two or three times he has reconstructed an entire day. He told me: I have more memories in myself alone than all men have had since the world was a world.

But this fabulous talent was not in the end an advantage for Funes; it was paralyzing:

I suspect that he was not very capable of thought. To think is to forget a difference, to generalize, to abstract. In the overly replete world of Funes, there were nothing but details, continuous details.

Indeed, the Plain Dealer article about Mr. Baron suggests some of the problems that a perfect memory might involve. The article reports that:

One of the others with the ability – a California woman named Jill Price, who recently released a book titled "The Woman Who Can’t Forget" – described it as paralyzing. She likened her memories to home movies playing nonstop in her head.

Baron bristles at Price’s portrayal of what he calls a gift. However, he acknowledged feeling like "an oddball" given his unusual talent.

He also described his days as "empty."

Our memories must be selective in order for us to be able to function. Our brains must sort and sift, to clear away until only what remains is that which matters. Imagine a marriage where your spouse remembered with clarity your every frailty and shortcoming. Or how hard it would be if you couldn’t put setbacks and defeats behind you, but had to remember them, eternally and perfectly. We forget our college calculus, and even the name of that girl across the classroom whose eye caught yours for that sweet and blessed instant so long ago, because we have to move on.

The process of forgetting is a kind of refinement, a distillation of the essence, that permits us to see our lives not as a crazy quilt of sights and sounds, but as a progression that has a more general meaning and purpose. If we saw all at once, we could not see the center.

And the most important thing about memory, the thing we must never forget, is …um…

In the past week, plaintiffs’ lawyers filed a raft of new subprime and credit crisis related securities lawsuits. The cases involve a wide variety of claimants and defendants, and a diverse array of legal theories. But while the lawsuits themselves are diverse, they do all evidence a common theme, which is that the subprime and credit-crisis related litigation wave continues to surge on.

American International Group: The most prominent lawsuit filed in the past week is the securities class action lawsuit filed in the United States District Court for the Southern District of New York against American International Group, its CEO Martin Sullivan, its CFO Steven Bensinger, and two other officials. A press release describing the lawsuit, which was filed by the Bernstein Litowitz Berger & Grossmann firm on behalf of the Jacksonville Police and Fire Pension Fund, can be found here. A copy of the complaint can be found here.

According to the press release, “Defendants repeatedly reassured investors that AIG had successfully insulated itself from the recent turmoil in the housing and credit markets due to its superior risk management. In particular, defendants touted the security of [American International Group Financial Products] ‘super senior’ credit default swap portfolio, making numerous statements that this portfolio was secure and that AIG’s method for accounting for this portfolio accurately reflected its value.” The press release goes on to state that:

Investors began to learn the truth regarding AIG’s financial condition and the Company’s exposure to the mortgage market when, on February 11, 2008, the Company disclosed that its outside auditor had determined that there was “material weakness in its internal control” over the financial reporting and oversight relating specifically to its accounting for the CDS portfolio, and that the Company was revising the loss valuations it previously reported. Under the new valuations, losses on the CDS portfolio more than quadrupled – from the $1.4 billion reported on the CDS portfolio just weeks before to over $4.5 billion. Two weeks later, on February 28, 2008, AIG disclosed that the market valuations on the CDS portfolio would increase to $11.5 billion and revealed for the first time that the Company had notional exposure of $6.5 billion in liquidity puts written on collateralized debt obligations (“CDOs”) linked to the sub-prime mortgage market.

Finally, on May 8, 2008, the Company disclosed that market valuation losses on the CDS portfolio for the quarter climbed an additional $9.1 billion, for a cumulative loss of $20.6 billion, and that the Company was expecting actual losses on the portfolio to be about $2.4 billion. As a result of these disclosures, the price of AIG stock plunged from a Class Period high of $75.24 per share on June 5, 2008, to $38.37 per share on May 12, 2008, wiping out tens of billions of dollars in shareholder value and causing damage to the class.

A May 22, 2008 New York Times article describing the AIG lawsuit can be found here. A May 23, 2008 Law.com article about the suit can be found here.

Falcon Strategies/Citigroup: Another prominent lawsuit filed during the last week involved a hedge fund affiliated with Citigroup, which is also a defendant in the lawsuit. The lawsuit is filed on behalf of all persons “who have tendered or been asked to tender their shares” in Falcon Strategies Two LLC. According to the plaintiffs’ lawyers’ press release (here), Falcon was established as a “multi-strategy fixed income alternative seeking to provide investors with absolute returns, current income and portfolio diversification.” However, the complaint (which can be found here) alleges that Falcon was “not conservative” but “employed bond arbitrage, carried commercial debt obligations, and held asset-backed mortgage investments” that declined in value when the markets failed.

The complaint is somewhat unusual in that, which it alleges affirmative violations of the federal securities laws, it does not expressly seek damages, but rather seeks a preliminary injunction to enjoin the tender offer until the defendants correct the “allegedly false and misleading” tender memorandum.

A separate lawsuit against a Falcon Strategies fund seeking damages and filed on behalf of Fifth Third Bank is detailed in a May 20, 2008 Wall Street Journal article (here). The Falcon Strategies fund had previously been the target of a separate securities class action lawsuit, but that lawsuit was voluntarily dismissed (refer here concerning this prior dismissed lawsuit).

The Falcon Strategies lawsuit is the second subprime or credit crisis-related securities class action lawsuit brought against a Citigroup-affiliated hedge fund. In early May 2008, investors brought a securities lawsuit against MAT Five LLC, Citigroup and other defendants alleging misrepresentations in MAT Five’s placement memorandum (Refer here for further background regarding the MAT Five lawsuit.)

Bank of America: In addition to these two lawsuits, investors also brought a securities class action lawsuit against Bank of America and related entities on behalf of all persons who purchased auction rate securities from the defendants during the period May 22, 2003 and February 23, 2008. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

I have written extensively about the auction rate securities lawsuits in prior posts, most recently here.

National City/Harbor Bank: Finally, in the fourth of last week’s flotilla of new subprime lawsuits, on May 20, 2008, the defendants removed to the United States District Court for the Northern District of Ohio a lawsuit that had been filed in the Court of Common Pleas of Cuyahoga County Ohio on behalf of all persons who acquired shares of National City Corporation in connection with National City’s December 1, 2006 acquisition of Harbor Bank. A copy of the complaint and removal petition can be found here.

The plaintiffs allege that the Registration Statement issued in connection with the merger contained material misrepresentations and omissions concerning National City’s lending practices, financial results and liquidity. In particular, the complaint alleges among other things that the Registration Statement failed to disclose that National City was “dangerously overexposed” to “risky and impaired CDOs” and that the company had “failed to properly account for its highly leveraged loans and mortgage securities.”

National City previously has been sued in a securities class action lawsuit (as I discussed in a prior post, here) filed on behalf of its shareholders. But this new lawsuit is filed on behalf of a distinct set of claimants and is based on a different set of alleged misrepresentations, and therefore in my view it represents a separate new lawsuit. As discussed below, I have accounted for it separately in my running tally of subprime-related securities lawsuits.

The lawsuits against National City on behalf of the former Harbor Bank shareholders alleges violations of Section 11 of the ’33 Act, but was filed initially in state court under the ’33 Act’s concurrent jurisdiction provisions. I have previously noted (refer here) the plaintiffs’ lawyers’ recent interest in attempting to pursue ’33 Act claims in state court. While defendants routinely remove these cases to federal court, the plaintiffs’ lawyers’ have has some success in having the cases remanded to state court (refer here). While one can only speculate on the plaintiffs’ interest in pursuing these cases in state court, it is nonetheless a very interesting development that possible represents a new trend in securities litigation prosecution.

One other interesting thing about the National City/Harbor Bank lawsuit is that in addition to National City itself and its current and former directors and officers, the complaint names as a defendant, National City’s auditors, Ernst & Young. There have been some lawsuits where the target company’s outside auditors have been named as defendants (for example, refer here regarding the amended complaint in the Countrywide subprime litigation where the companies’ auditors have been named). The bankruptcy examiner in the New Century case also suggested that there may be claims against the company’s auditors (refer here for a discussion of this report). However, so far, the auditors have been an infrequent target, likely because of the Stoneridge decision. The cases involving outside auditors have tended to be bases where an offering of securities is involved, and the auditors potentially have their own primary liability in connection with the offering.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the National City/Harbor Bank complaint.

Run the Numbers: With the addition of last week’s four new subprime and credit-related securities lawsuits, the current tally (refer here) of the subprime related securities lawsuits now stands at 85, of which 45 have been filed in 2008. With the addition of the new Bank of America lawsuit, the total number of auction rate securities lawsuits now stands at 17.

While the numerical specifics are important, the more important point is that the subprime and credit crisis-related litigation wave continues to churn on, the passage of time apparently doing nothing to diminish its intensity.

Speakers’ Corner: On Thursday May 29, 2008, I will be in New York speaking on a panel at IQPC’s 4th Securities Litigation Conference (brochure here). The panel on which I am participating is entitled “Discussing Recent Trends in Director & Officer Liability (D&O) Liability,” and includes as co-panelists Ray DeCarlo of AIG and Adam Savett of RiskMetrics.

Company managers are increasingly sophisticated about D&O liability insurance. Largely as a result of the corporate scandals from earlier in this decade, what used to be a peripheral and disfavored topic is now a top agenda item in many C-suites and boardrooms. But even as company officials have developed a deeper appreciation for the importance of D&O insurance, many misunderstandings about D&O underwriting persist. One thing that is frequently misunderstood is what D&O underwriters are looking for.

This post is intended to provide an overview of the key components of public company D&O underwriting. Of course, the underwriting concerns for different specific companies could vary substantially. In addition, there are many D&O insurers, and underwriting practices vary significantly between (and, regrettably, even within) insurers. That said, there are certain common elements that will likely be part of the D&O underwriting for any company. These elements are listed below. A great deal more might be said about each of these items, but in the interest of brevity, I have provided a summary description only.

1. The Company’s Basic Characteristics: First and foremost, the underwriter must understand the company’s basic profile. Specifically, the underwriter will want to know the company’s size (by market capitalization) and industry. These factors may seem basic and obvious, but they will nonetheless have a significant impact on an underwriter’s willingness to accept a risk, as well as on the price, terms and conditions likely to be offered.

2. The Company’s Financial Picture: A basic component of D&O underwriting is developing an understanding of the company’s financial circumstances, particularly its key income statement components (revenue, expenses and expense ratios, etc.) and balance sheet items (especially cash and other liquid assets, debt, and reserves/accruals). Although there are many important financial issues, the key question is whether or not the company has sufficient cash or available credit to fund its operations and service its debt during the proposed policy period.

3. The Company’s Accounting Practices: A very specific component for underwriters in developing an understanding of the company’s financial picture is developing an understanding of the company’s accounting policies and practices. The most important issue here is usually revenue recognition, but depending on the kind of company at issue, other critical issues may be the company’s practices regarding reserves and accruals, and these days, asset valuation.

4. The Company’s Corporate History and Structure (Including M&A): Because share offerings, financing activities and M&A activity are the kinds of events that often generate claims, the underwriter will want a complete understanding of the company’s involvement in all of these kinds of activities.

5. Continuity Risk (Things That Have Already Happened): An underwriter will want to establish whether the company has already experienced events or circumstances that could lead to subsequent claims. The list of potential problems could be infinite, but the kinds of things that will particularly attract the underwriter’s concern are things like significant stock price drops, earnings disappointments, regulatory setbacks, product recalls, adverse litigation developments, officer resignations, and so on.

6. Going Forward Risk/Vulnerabilities: A key risk attribute for any company is whether or not the company is susceptible to a single event or change that could substantially alter the company’s fortunes. These kinds of vulnerabilities include such things as: dependence on a single customer, contract, product or supplier; a looming regulatory milestone for a company with a single product in development; or a company-dependent debt obligation with a single-trigger acceleration clause or covenant.

7. Stock Price Volatility: A company that has a share price that dramatically registers even small events is capable of producing large shareholder-style damages. For that reason, companies with volatile stock prices represent a disfavored risk class for many underwriters. 

Some underwriters go so far at to make stock price volatility the most important component in their risk selection and stock price algorithms. I have always felt this analysis represents both an oversimplification and a confusion of correlation and causation. Simply put, while many companies involved in securities class action lawsuits have volatile stock prices, not all companies with volatile stock prices are involved in securities lawsuits. In my view it is the presence or absence of the above identified factors are more indicative of risk than volatility alone.  

8. Company Management and Executive Compensation: The background and experience of the company’s senior management and board members is important information. Underwriters will be particularly interested in any changes in the lineup, and in particular will want to understand the reasons for any changes.

A significant issue related is executive compensation. Some industry observers go so far as to assert that outsized executive compensation is the single most reliable risk marker, as it usually invites a host of dangerous (and sometimes destructive) behaviors. Certainly, many of the most egregious corporate scandals in the last several years have involved excessive executive compensation. Accordingly, underwriters will consider executive compensation information as an important component of the risk analysis.

9. Insider Trading: The most dangerous component of a serious securities class action lawsuit is the presence of significant insider trading at suspicious time and in suspicious amounts. A skilled underwriter will plot the timing of insider trades on the company’s stock graphs to understand who is trading and when. The corollary of this point is that the underwriter will also be interested in the company’s insider trading policy, and in particular will look to see that the company has well-established trading windows and rational trading blackouts, as well as an effective compliance officer.

10. Disclosure practices: The nature, content and tone of the company’s public disclosures are important risk indicators. Underwriters are concerned about companies that devote a lot of energy to generating hype. They are also focused on companies that are very publicly setting and straining to meet very specific short-term earnings estimates. Again, the corollary is that companies with conservative disclosure practices, particularly those that avoid specific, short-term earnings guidance, are viewed more favorably.

11. Corporate Governance: A detailed review of a company’s corporate governance practices is an important part of public company underwriting. However, most underwriters understand that standard corporate governance practices alone are no guarantors that a company will not be involved in a claim. But by the same token, underwriters understand that companies that are actively implementing best practices are the kinds of companies that are interested in trying to play by the rules and perhaps less likely to have problems elsewhere – and better able to defend themselves if a claim does arise.

There is obviously a lot more that might be said about each of these items. In addition, there are a host of other factors that could be relevant to any specific company or to companies in certain industries.

A common misconception is that the D&O underwriting process is like picking a stock. (Frustratingly, some underwriters labor under the misimpression, too.) Many company officials think that their role in the underwriting process is to tout the company and its prospects, as if they were on a road show speaking to prospective investors and analysts. Because most underwriters are by nature suspicious of hype, an underwriting meeting characterized by a high level of salesmanship can be counterproductive.

Underwriters generally do not care whether or not a company’s stock is a good investment, as such. Companies that are mediocre investments are often (although not always) attractive D&O risks, and companies that are Wall Street darlings are sometimes rotten D&O risks. Underwriters are trying to figure out if a company is susceptible to a claim during the policy period, which is often a very different question than whether or not the company’s stock is doing or will do well.

Another common misunderstanding is the expectation that if the company does or does not do certain things, the company ought to get a discount of a certain type or amount. In the soft insurance market that has persisted in recent years, risk specific discounts are hard to isolate, since many companies are enjoying favorable pricing. But more to the point, because underwriting is an uncertain science, the most important factors in determining the price, terms and conditions to be offered are the company’s outward characteristics, which are categorical attributes.

Which is not to say that better managed companies will realize no benefit. But rather than a discount, the benefit is often in the form in the absence of a debit. Or, to put it another way, companies presenting certain specific negative risk factors will be debited, even in the current underwriting environment.

All of that said, there unquestionably are things companies can do to advance their interests during the underwriting process. Working with a skilled insurance professional, a company can identify and address likely underwriting concerns, in an effort to inoculate the company against adverse underwriting perceptions. Moreover, it will be useful for every company to adopt a systematic, timely and business-like approach to the underwriting process, as these practices will expedite the process, remove potential impediments, and encourage efficiencies that benefit all process participants.

The foregoing is merely a summary; there is a great deal more that could be said about all of the above. There are good resources available to supplement the above. One very good resource is the curriculum materials created by the Professional Liability Underwriting Society (PLUS) entitled “Public/Financial D&O Insurance” and available on the PLUS website (here).

Because this is one of those topics on which a great deal more might be said, I would like to encourage readers and observers to post their comments to this blog. I always welcome audience participation but I am particularly interested in readers’ comments on this topic.

In my preceding post, I quoted recent reassuring words from Treasury Secretary Henry Paulson about the current credit crunch. Billionaires Warren Buffett and George Soros apparently have a less sanguine view, and there is in any event substantial recent evidence to support the view that, whether or not the worst is over, the effects will be felt for some time to come.

According to news reports (here), Warren Buffett told reporters in Europe yesterday that “I don’t necessarily think we’re halfway through or necessarily a quarter of the way through the effects throughout the general economy. The initial effects are felt by people who really did the silliest things, but you can have a whole bunch of domino-type effects that eventually can get to people who are doing fairly sound things.” Buffett added that “I think there will be rippling secondary, tertiary effects.”

Soros, while willing to concede (here) that the “acute phase” of the crisis may have passed, also said that “now we have to feel the effects,” which he said might “almost inevitably” include recessions in the U.S. and U.K.

An even more pessimistic voice is that of Meredith Whitney, the analyst for Oppenheimer who correctly predicted disaster for Citigroup and others last fall. She recently said (here) that "the credit crisis is far from over" and "what lies ahead will be worse that what is behind us." Dang.

There are already a wide variety of effects that are rippling through the economy and affecting a diverse array of companies, even outside the financial sector. For example, on May 19, 2008 Bloomberg reported (here) that “more than 300 companies are struggling to value auction rate bonds” that they are carrying on their balance sheets. These companies’ auction rate securities investments were valued at $98 billion as recently as January 1, 2008.

“About half” of these companies have “reported losses totaling $1.8 billion as the markets for securities, sold as higher-yielding alternatives to money markets, seized up.” Among the companies the Bloomberg article names as having taken auction-rate securities-related write-downs are UPS, Google, HCA and Teva Pharmaceuticals. But while half of the companies holding these assets may have recognized the valuations issues, the other half have not, and even the companies that have taken some recognition have the issue of whether or not they got it right.

The wide dispersion of these and other credit crunch-related exposures throughout the economy puts pressure on many companies to recognize the risk; companies that delay or avoid recognition may be laying in problems down the road. As one commentator said in another Bloomberg article (here), “the smart people are the ones who’ve identified the problems, put them out there in full transparency, and addressed them by raising more capital. There is still billions of dollars of crap out there that hasn’t worked its way through the system.”

The May 19, 2008 Bloomberg article in which this latter statement appeared is entitled “Banks Keep $35 billion Markdowns Off Income Statements” (here). The article describes multiple financial institutions that are “failing to acknowledge their in their income statements at least $35 billion of additional write-downs included in their balance sheets.” A commentator in the article notes that “keeping the markdowns off income statements just delays the realization of losses.” Indeed, the article suggests that ignored bad debt and postponing the inevitable losses is one of the reasons behind Japan’s decades long economic slump.

Behind every postponed day of reckoning is an optimistic hope that the reckoning might not just be delayed but perhaps avoided altogether. And perhaps things will come right. But the kinetic potential for the kinds of secondary and tertiary ripple effects Buffett projected inheres within every one of these postponements, laying the potential for further disruption when the day of reckoning arrives.

The consequences of these secondary and tertiary effects inevitably will include litigation, as is perhaps illustrated by the lawsuit, described in today’s Wall Street Journal (here), in which Fifth Third Bank has sued an insurer and a brokerage firm that arranged an investment for the bank in the Citigroup Falcon Strategies hedge fund. (A copy of the complaint can be found here.)

Fifth Third’s investment involved a complex life insurance investment, in which the aggregate premiums were invested in a diversity of assets. The complaint alleges that the defendants failed to monitor and manage Fifth Third’s $612 million investment, particularly when changing conditions (triggered by the credit crunch) should have triggered a reallocation of assets. This lawsuit demonstrates the range of potential litigation issues and the breadth of potential litigation targets that may become involved in future litigation. 

In a post on this blog last December (here), I discussed “the truth telling yet to come” in connection with the subprime meltdown. In many ways, the phrase is even more apt now. The dynamic possibilities of the truth telling yet to come include the litigation yet to come, as well. And as Buffett said, we are not necessarily even a quarter of the way through this yet.

A June 1, 2008 article in Corporate Counsel entitled “Wipeout!” (here) describes the credit crisis-related litigation to date and the litigation yet to come. Among other things, the article quotes one commentator as saying that “we haven’t seen most of the litigation yet.”

Top Ten Securities and Corporate Law Review Articles: The Securities Litigation Watch blog (here) has reproduced (with hyperlinks) the list of the Top Ten Corporate and Securities Law Review articles of the year. I was very pleased to see that my good friends Tom Baker and Sean Griffith’s article "The Missing Monitor in Corporate Governance: The Directors’ & Officers’ Liabiltiy Insurer" (here) made the list. I discussed Professor Baker and Griffith’s article at length in an earlier post, here.

A Big Fee Anwhere (But Especially in Tajikistan): A May 20, 2008 Financial Times article about lawyers’ fees entitled “Time to Stop the Lawyers’ Clock from Ticking” (here), noted that observers had

expressed concern about the £50m in fees that Herbert Smith, another top firm, expects to bill on behalf of Tajikistan in a dispute over alleged corruption at a state-owned aluminum smelter.

The projected costs, revealed at a High Court hearing in April, would represent 2.7 per cent of the central Asian nation’s gross domestic product, where the average monthly wage stands at a paltry $63.

According to news reports (here), Treasury Secretary Henry Paulson has added his voice to the growing chorus declaring that the worst of the credit crisis may be past. Paulson reportedly said that “we are seeing signs of progress as capital and credit markets stabilize.” We can all hope for the sake of the financial markets, and indeed, the entire U.S. economy, that Paulson is correct.

But while the top level indications may be encouraging, it would be premature at this point to conclude that the subprime and credit crunch related litigation wave is spent. If the lawsuit filings just in the last week are any indication, the litigation wave will continue to roll on for the foreseeable future.

For example, on May 16, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the United States District Court for the Central District of California against Downey Financial Group and certain of its directors and officers. The plaintiffs’ counsel’s May 16 press release can be found here and a copy of the complaint can be found here.

According to the press release, on March 17, 2008, Downey (a savings and loan holding company) reported (here) an “increase in non-performing assets to almost 11% of total assets, up from 1.2% in May 2007.” According to the complaint, the “true facts, which were known to the defendants but concealed from the investing public” were that:

(a) defendants’ portfolio of Option ARMs contained millions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (b) prior to the Class Period, Downey had seen Countrywide’s growth and had started to get more aggressive in acquiring loans from brokers such that the loans were extremely risky; (c) defendants failed to properly account for highly leveraged loans such as mortgage securities; (d) Downey had very little real underwriting, which led to large numbers of bad loans that would cause huge numbers of defaults; and (e) Downey had not adequately reserved for Option ARM loans, the terms of which provided that during the initial term of the loan borrowers could pay only as much as they desired with any underpayment being added to the loan balance.

I have written previously (here) about the litigation threat that Option ARMs could present. Downey is far from the only financial institution that is vulnerable to defaults and delinquencies as Option ARMs readjust. Moreover, all lending institutions remain vulnerable to increasing defaults as rising unemployment, and rising energy and food costs (among other things), continue to undermine borrowers’ ability to remain current on their mortgages and other debt. Other lenders undoubtedly will be reporting increases in non-performing assets in the weeks and months ahead – which is one reason why the subprime and credit crisis litigation wave may have long way to go before it loses momentum.

In addition, on May 12, 2008, plaintiffs initiated a shareholder class action lawsuit in the United States District Court for the Eastern District of Michigan against private mortgage insurer MGIC Investment Corp. and its CEO and its CFO. Refer here for a copy of the complaint. MGIC’s woes relate back to its failed 2007 attempt to merger with Radian Group, as well as the deterioration of the joint venture, Credit Based Asset Servicing and Securitization LLC (“C-Bass”), in which MGIC had entered with Radian. The July 2007 collapse of the C-Bass venture and the August 2007 termination of the pending merger of the two companies previously led to the filing of a securities class action lawsuit against Radian Group (about which refer here).

The MGIC complaint alleges that even after the demise of the C-Bass venture and after the termination of the Radian merger, MGIC continued to struggle, and on February 13, 2008, the company announced (here) a loss for the fourth quarter of 2007 of $1.47 billion, part of a full year 2007 loss of $1.67 billion.

MGIC’s financial challenges, which continued well after the company’s mid-2007 crises, underscores that fact that many companies are continuing to grind through tough financial circumstances. MGIC’s continuing challenges suggest that even if, as Secretary Paulson observes, the worse of the credit crisis may have passed, the fallout will continue to filter through the system for many months to come. And as companies continue to wrestle with these circumstances, additional litigation, like that filed against MGIC, will continue to emerge.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the MGIC complaint.

Run the Numbers: With the addition of these two new lawsuits, my running tally (here) of subprime and credit crisis related securities class action lawsuits now stands at 81, of which 41 have been filed during 2008.

An FCPA Follow-on Litigation Variant: In prior posts (most recently here), I have written about the growing liability threat arising from civil litigation following after Foreign Corrupt Practices Act enforcement activity. In a May 2008 article entitled “Suing Bribing Competitors: The Next Tool in the International Anti-Corruption Arsenal?” (here), James Maton and Joshua Gardner of the Edwards Angell Palmer & Dodge law firm describe yet another litigation threat arising out of corrupt practices enforcement proceedings.

The authors’ describe increasing litigation activity involving claims by companies that lose bids to bribing competitors. The disappointed bidders bring private lawsuits against the companies that are awarded the contracts. The losing bidders seek to recover lost profits, as well as costs wasted in bidding. Plaintiffs have asserted these kinds of claims under federal and state antitrust laws, RICO, and state common law theories such as intentional interference with contract and unjust enrichment.

The authors conclude that notwithstanding the litigation hurdles involved, “these types of private lawsuits are bound to increase in the United States, England and elsewhere.” All of which supports a view I have expressed numerous times on this blog – namely, the as anticorruption enforcement activity increases, the threat of related private civil litigation also increases, and that this litigation threat represents an important emerging liability risk for companies and their directors and officers.

Blog Bites Man: This past week, The D&O Diary passed its second anniversary, as two years have now passed since the blog’s May 10, 2006 launch. During its second year, the blog passed several important milestones, including most significantly its move from Blogger to LexBlog. And after almost 400 blog posts, The D&O Diary now has nearly 1,500 e-mail and RSS subscribers.

I would like to thank The D&O Diary’s readers for their continued support. I remain a highly motivated blogger because of the regular encouragement I receive from the blog’s readers.

I would also like to thank everyone who has sent me links, suggestions and comments over the last two years. I get most of my best material from readers’ suggestions, and I hope everyone out there will continue to send me the good stuff that I might not otherwise find. Please keep your suggestions coming. Thanks to all for their support for The D&O Diary.

In a very interesting May 15, 2008 paper entitled “Do Options Backdating Cases Settle for Less?” (here), NERA Economic Consulting takes a look at the options backdating-related securities class action lawsuits settlements to date, and concludes that “in the cases that have settled to date, the amounts paid to plaintiffs have been substantially lower than in comparable non-backdating class actions.” NERA’s analysis is that the options backdating class action lawsuits are settling for half the amounts forecast by NERA’s own prediction model.

Having made this rather provocative observation, NERA then concedes that only a fraction of the options backdating-related securities class action lawsuits filed have yet settled. Clearly one factor that may be involved is that the weakest cases may have settled first, a consideration that the NERA study expressly acknowledges.

Nevertheless, in attempting to understand the variation between the settlements to date compared to the expected range of settlements based on NERA’s model, the NERA report does consider the possibility that “shareholder suits with backdating allegations are perceived as weaker on the merits than other class actions.” The report also considers the possibility that future options backdating settlements, which might include more serious cases, could be more in line with other securities class action settlements.

I have several observations about the NERA analysis, the first of which is that is important for all of us to keep a running tally of outcomes, to make sure we all know and keep track of what is happening. The fact that this study comes from NERA suggests that it will (appropriately) carry weight and credibility.

That said, it should also be noted that the NERA study is based on a small sample, only six settlements out of 37 options backdating related securities class action lawsuits. (The total number of lawsuits according to my tally, here, is only 36, but I am willing to go with their number for these purposes, which is close enough anyway.)

Not only is the sample small, but it seems to have been amputated at a couple of critical points. That is, for reasons that are not explained in the report, the NERA dataset does not include either the Mercury Interactive settlement ($117.5 mm) or the Vitesse Seminconduct settlement ($10.2 mm). If I know NERA, there are probably some very good reasons why they excluded these settlements, but the report does not explain or even refer to the omission of these settlements. Given the size of the Mercury Interactive settlement in particular, the omission of these settlements could have had a significant impact on the analysis, so their omission could be significant.

UPDATE: Dr. Branko Jovanovic, one of the author’s of the NERA report, was kind enough to call me and politely point out that the report actually refers, in footnote 3, to the fact that the report’s authors chose to exclude the Mercury Interactive and Vitesse Semiconductor settlements from the analysis because some but not all defendants had settled. (That’s what I get for trying to write blog posts in a hotel room in Toronto without the ability to print out and read documents in hard copy form. Reading the report on a laptop screen, I just missed the footnote). Dr. Jovanovic points out that if the two settlements had been included, it would have increased the difference between expected and actual settlements.

The other thing about NERA’s analysis is that as a result of the small dataset, extreme individual results could be skewing the average. In particular, according to the report, the Rambus options backdating related securities class action lawsuit of $18 million, was only 8.3% of predicted. For me, an outlier result like that suggests that it is not representative, and in fact some case specific factor may explain the outcome. In any event, an extreme result like that clearly pulls down the average. While the exclusion of the Rambus result would still not eliminate the variation from the predicted range, it would reduce the difference.

I also think it is significant in considering whether the options backdating cases are or are not deviating from expectations that dismissals should be taken into account as well as settlements. According to my running tally of option backdating related settlements, dismissals and denials (which may be accessed here), six of the 37 (or is it 36?) options backdating related securities class action lawsuits have been dismissed. (Some of these dismissals are without prejudice). I am not 100% sure which way this cuts, but I think the number of dismissals is a relevant consideration to any analysis of whether or not outcomes are within predicted ranges. The dismissals may also provide some explanation, or at least context, for the variation between settlements to date and predicted ranges.

All of that said, I reiterate my appreciation to NERA for their effort to keep track of what has happened so far. The value of NERA’s analysis is in its provision of a status update, which is a sevice that we can all hope that NERA will continue as the cases develop.

For the sake of completeness, I urge all readers interested in these topics to review the analysis of options backdating securities class action settlements on the Securities Litigation Watch blog (here), which among other things notes that these cases are settling more quickly on average than other cases, which clearly might be a factor in explaining settlement outcomes. The SLW’s analysis not only takes into account the settlements that NERA’s report omits, but it also considers the dismissals as well.

One final observation is that NERA’s analysis relates solely to options backdating securities class action settlements, and does not refer to or include options backdating derivative lawsuit settlements.  For further information regarding options backdating derivative lawsuit settlements, please refer to the table I am maintainting, here.

CFO.com has an article discussing the NERA report here.